Hidden champions or black sheep?

The role of underpricing in the German mini-bond

market
Mark Mietzner, Juliane Proelss & Denis Schweizer

Abstract
This paper presents a first empirical examination of all available German mini-bond offerings
between 2010 and 2015. We compare the default probability according to a mini-bond’s
initial rating with that implied by credit risk models and show that rating agencies can create
rating inflation by issuing overly favorable ratings. This creates a favorable opportunity for
lower quality firms to compete for funding. In this environment, high-quality firms have an
incentive to use mini-bond underpricing to signal their quality. Our data highlight that,
according to information-based corporate finance theory, higher underpricing is correlated
with higher quality mini-bond issuer`s and lower early default rates.

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Introduction
In the aftermath of the recent financial crisis, many banks became either unwilling or unable
to provide financing to companies. In response, 300 German non-financial corporations
raised over €150 billion by issuing straight bonds. This total represented double the number
of corporations and the amount raised over the 3 years prior to the crisis (authors’ own
calculations, based on Thomson Reuters SDC data).

This development is especially striking given the traditionally close financing relationships
between German corporations and banks. But it also highlights the growing importance of
external capital market-based financing. The desire by corporations to decrease their
dependence on bank financing post-crisis has been well documented in the literature (see,
e.g., Davis and Stone 2004; Deutsche Bundesbank 2012; Nassr and Wehinger
2015).Footnote 1

However, note that many small and medium-size firms (SMEs or “Mittelstand” in Germany)
only recently entered the public bond market for the first time. These companies, often world
market leaders, are the backbone of the German economy and are considered “hidden
champions” (see Simon 2009). They play a pivotal role in modern, knowledge-based
economies because they are an important source of new jobs, radical innovations, and
productivity growth. The Mittelstand classification has become an internationally recognized
stamp of high quality.

But despite their importance, German SMEs frequently face financing constraints, which limit
their growthFootnote 2 and can threaten their survival (Audretsch and Elston 1997). The rise
of “mini-bonds,” which are public bonds issued in special SME bond segments, is one
response to this issue. An example was the bondm segment of the Stuttgart Stock
Exchange, established in May 2010 (but subsequently shut down).Footnote 3 Mini-bond
issuers are predominantly first time issuers and, thus, inexperienced in raising debt publicly
in these specialized market segments. Issue sizes vary considerably, from about €2 million
to €200 million, and nominal values tend to be small, mostly €1000. They thus generally
attract private investors.Footnote 4

The majority of mini-bond issuers are rated BB, BBB, or higher at the time of issuance (see
Table 5). According to, e.g., Standard & Poor’s default tables, these ratings would indicate
2–9% probabilities of default over a 5-year time horizon. However, ratings in the mini-bond
segment usually come from smaller, local agencies, such as Scope, Euler Hermes, Feri, or
Creditreform, instead of the “Big Three” agencies (Fitch, Moody’s, Standard & Poor’s).

The mini-bond market segment has recently been the subject of extensive media coverage,
primarily because of an increase in defaults. Given their initial ratings and perceptions as
hidden champions, this was somewhat surprising. In fact, approximately one-fifth of all
mini-bonds issued in the bondm segment ultimately defaulted between May 2010 and
November 2014, which may have contributed to its shutdown.Footnote 5 Even more
importantly, with a nearly 20% default rate, the real default risk was substantially higher than
that indicated by the average initial issuer ratings, which corresponded to a nominal bond
value of about €800 million of risk by the end of 2014.

High default rates that deviate from initially indicated credit risks not only raise doubts about
the quality of the SMEs, they also suggest wide differences in “quality.” Furthermore, such
ratings unreliability can make it difficult for investors (particularly private investors) to
differentiate between hidden champions and black sheep, or poor performers.

Ratings are an integral part of the bond market. They provide creditors and investors with
critical information, thereby reducing information asymmetries (see Weinstein 1977; Griffin
and Sanvicente 1982). Some investors rely solely on ratings (see Kaplan and Urwitz 1979);
others are restricted from investing in non-investment-grade bonds, meaning ratings below
BBB for Standard & Poor’s or below Baa for Moody’s. Thus, with any reduction in accuracy,
rating agencies fail, at least to some extent, to provide the certification that investors
demand.

Against this backdrop, corporate finance theory suggests it can be advantageous for
high-quality firms to use “credible” signals to better separate themselves from lower quality
firms.Footnote 6 Considering the market for microfinance (Crowdfunding), Vismara (2017)
and Ahlers et al. (2015) also apply the signaling theory to predict the probability of proposal
success and Allen and Faulhaber (1989) use a setting similar to ours, where companies go
public in an initial public offering (IPO), and seek to issue subsequent equity via seasoned
equity offerings (SEOs). They show that high-quality firms tend to sell their equity “too
cheaply” in IPOs. The underpricing gives investors a discount on the equity price and is
perceived as a positive and reliable signal of quality. The rationale is that low-quality firms
have almost no incentive for underpricing, because their primary desire is to raise the
highest amount possible. They assume investors will realize their low quality over time and
will consequently be unlikely to provide further capital in an SEO.Footnote 7

Similarly to IPO markets, when rating agencies fail to reduce asymmetric information,
high-quality issuers interested in developing the bond market as a long-term financing
channel will likewise have incentives to use underpricing to signal their quality. Thus, a firm’s
bond underpricing can be viewed as a quality signal.

To empirically test Allen and Faulhaber’s (1989) predictions in the German mini-bond
market, we analyze a unique, hand-collected sample of 118 mini-bonds from their inception
in 2010 through May 2015. We first present corroborating evidence that rating agencies tend
to release overly favorable ratings (also known as ratings inflation), or overly low
probabilities of default, as measured by subsequent realized default rates. This leaves
investors with considerable uncertainty about the true underlying levels of credit risk and
suggests a favorable opportunity for black sheep to potentially mix undetected with hidden
champions.

Next, we explore how hidden champions react to ratings inflation conditions, aiming to show
quality by using underpricing as a signal. We find a statistically significant average
underpricing of 0.68%. In multivariate analyses, we relate mini-bond underpricing to proxies
for firm quality. The results are consistent with the notion that firm quality is positively
correlated with mini-bond underpricing, as per Allen and Faulhaber (1989). Our results also
suggest that low-quality German SME firms not only issue “overpriced” debt securities, but
they may also time their bond issues to a temporal favorable opportunity because of
ambiguous signals about an issuer’s true credit risk.

Finally, we test whether SMEs use underpricing as a credible signal of differentiation. We tie
early mini-bond defaults to underpricing and several other controlling variables. If
underpricing provides a definitive separation between high- and low-quality firms, we expect
to find a negative relationship between early defaults and underpricing. Our data support
this.

In summary, our main contribution is the identification of underpricing as an effective

signaling mechanism in the mini-bond market, where information asymmetry is particularly
pronounced given the heterogonous nature of bond issuers. Our results are consistent with
the notion that high-quality firms use underpricing as a credible but costly signal to
differentiate themselves from low-quality firms. Several robustness checks do not alter our
results.

To the best of our knowledge, this paper is the first to analyze mini-bond offerings in
Germany as a possible response to the continuing financing difficulties SMEs face across
Europe (as documented in a survey by the European Central Bank since the beginning of
the recent financial crisis). Mini-bonds as a financing channel are not unique to German
SMEs. They have attracted the attention of other EU countries, such as Italy and U.K.,
where similar start-up difficulties exist. We thus contribute to the understanding of how to
construct appropriate policy and market designs to provide high-quality SMEs with financing.

A fuller understanding of the mini-bond segment is critically important because the market
for corporate financing is changing and developing rapidly in Germany and across Europe.
Dependence on bank financing is concurrently decreasing. And, given that Germany plays a
fundamental role in the European economy, adverse developments there can potentially
have negative spillover effects to other EU countries.

The remainder of this paper is organized as follows. Section 2 discusses the related
literature, while Section 3 introduces the data. We describe the methodology of our empirical
analysis in Section 4. Section 5 presents our results, and Section 6 explores the robustness
of our findings. Section 7 concludes.

Hypothesis development
As we noted earlier, credit ratings are assumed to signal firm creditworthiness, thus, helping
reduce information asymmetries between issuers and investors (see, for example, Weinstein
1977; Wansley and Clauretie 1985; White 2010). Investors often use ratings to assess an
investment’s (credit) riskiness and to price debt securities.

According to this view, Faulkender and Petersen (2006) document that firms with credit
ratings can increase their leverage by raising more external debt. Similarly, Sufi (2009) finds
that firms that recently received a loan rating are able to raise (more) external funds from
less informed investors, which support the predictions of Boot et al.’s (2006) model.

Furthermore, it has been well documented that credit ratings are related to yield spreads,
meaning that companies of lower creditworthiness issue speculative-grade bonds (e.g., junk
or high-yield bonds) and must bear higher interest payments than higher quality firms due to
higher default risk (Gabbi and Sironi 2005; Creighton et al. 2007; May 2010).

In summary, credit ratings are highly decision-relevant for investors because they can help
bridge asymmetric information and are a necessary condition for well-functioning bond
markets. Nevertheless, several scandals, such as the bankruptcy of Enron in November
2001 and the role agencies played at the beginning of the recent financial crisis, have called
into question their reliability and informational content (see, e.g., White 2010; Bolton et al.
2012). In fact, credit rating agencies sometimes release and then update their ratings with a
substantial time lag, which can reduce their value as timely and reliable signals of borrower
quality (Galil and Soffer 2011). Even more importantly, as per Bolton et al.’s (2012) model,
rating agencies have a strong incentive to inflate ratings quality when more uninformed
investors are in the market, such as during an economic expansion. Becker and Milbourn
(2011) find that an increase in competition for credit ratings leads to a deterioration in quality.

The market for German mini-bonds began in 2010, a period of solid economic growth and
low interest rates, which resulted in strong investor demand. This created a continuously
increasing demand, as well as the issuance of new mini-bonds paired with less
well-established rating structures and standards at exchanges with distinguished mini-bond
segments (some did not even require a rating). Furthermore, the vast majority of issuers at
that time chose low nominal values of €1000, which attracted more uninformed and
inexperienced private investors, in addition to institutional investors. This occurrence fulfilled
both conditions of Bolton et al.’s (2012) model predicting inflated credit ratings.
Note also that, initially, it was not the “Big Three” rating agencies that fought for market
share. The market was divided among four local agencies (Creditreform, Euler Hermes, Feri,
and Scope), presumably because their services were cheaper and investors were not
sensitive to agency choice. However, the absence of the Big Three did not mean less
competition, particularly given that the lower ratings prices had already raised some doubts
about quality.

The lower ratings prices also lowered the hurdles to taking advantage of “ratings shopping”
in order to choose the most favorable rating (Becker and Milbourn 2011). This behavior by
issuers is more pronounced around the investment-grade boundary and is especially true for
our sample, which features predominantly BBB ratings (see Bongaerts et al. 2012). Such
behavior can result in inflated mini-bond ratings, even if local agencies maintain their
standards and produce theoretically unbiased ratings, simply because issuers rationally pick
the most favorable one (see Skreta and Veldkamp 2009; Griffin et al. 2013).

This argumentation is empirically supported by Bakalyar and Galil (2014), as well as by

Griffin et al. (2013) and He et al. (2012), who show that ratings inflation can be measured
when as few as three agencies are active in the market. Anecdotal evidence finds that, in
some cases, indicative ratings provided to potential mini-bond issuers were on average
below investment-grade (see Hedtstück 2014). Issuers responded by ratings shopping and
ultimately purchased a rating from a local agency instead (thereby contributing to the
inflation).

However, consider that “ratings shopping” does not necessarily lead to ratings inflation,
because agencies can account for it by rating more conservatively than they otherwise
would (see He et al. 2012). In this case, agencies would not be interested in “ratings
catering” (i.e., deviating from their own standards) if they are interested in potential future
business with the issuer or in increasing their market share (see Bolton et al. 2012; Griffin et
al. 2013). This behavior is especially pronounced when rating agencies enter a new market,
such as with mini-bonds (see Kisgen and Strahan 2010). Supporting our previous
arguments, we find that follow-up ratings are almost always conducted by the original
agency.

In summary, ratings shopping and ratings catering work in the same direction by creating an
incentive for agencies to inflate ratings. This leads to an environment of pronounced
information asymmetry. Reflecting our line of argumentation above, it seems plausible that
certain mechanisms are present in the mini-bond rating market because of, e.g., its
newness, competition among rating agencies, comparably low costs of ratings, mostly
investment-grade boundary ratings, and rating agencies that are interested in continuous
business with issuers.

Thus, our first testable hypothesis is the follwing:

Hypothesis 1: German mini-bond ratings are prone to ratings inflation as measured by higher
default rates than historical defaults in the respective rating classes.
When credit ratings are potentially inflated, investors will value signals provided by mini-bond
issuing firms more highly. A proven signal for this purpose in the IPO market is the
underpricing of newly issued shares.Footnote 8 Many studies have analyzed the signaling
power of IPO underpricing and documented how it can overcome or at least reduce
valuation uncertainty and subsequent asymmetric information problems (Ritter and Welch
2002; Ljungqvist 2007). According to signaling theory, high-quality firms underprice their
shares to convince outside investors of their quality (see, e.g., Rock 1986; Grinblatt and
Hwang 1989; Welch 1989).

However, underpricing is not costless and only high-quality firms can expect to recoup their
costs in subsequent issues. Low-quality firms may thus refrain from imitating high-quality
firms because they risk detection before subsequent issues. In their model, Allen and
Faulhaber (1989) conclude that underpricing can be a credible signal for distinguishing
between high- and low-quality IPO firms in equity markets.

We use the same rationale to explain underpricing in bond markets. Welch (2000) shows a
0.44% average underpricing for bond issues over 1994–1995. He also finds more
pronounced underpricing for lower rated firms.Footnote 9 Cai et al. (2007) document that
underpricing of initial bond offerings is larger for speculative-grade bonds.Footnote 10 These
results suggest that riskier companies, with more private knowledge about their
unobservable higher creditworthiness (higher level of information asymmetry), likely use
underpricing to signal to investors. However, the signaling mechanism would primarily be
attractive to higher quality firms.

Assuming credit ratings are not inflated, high-quality companies would not need to signal
their quality by underpricing, because their ratings are observable and a true reflection of
quality. However, as soon as ratings become inflated and of low quality, high-quality firms
may begin to use underpricing to, e.g., reduce financing costs in subsequent rounds. This
view is supported by Hale and Santos (2006), who show that bond underpricing declines for
subsequent offerings. It also confirms Allen and Faulhaber’s (1989) signaling hypothesis.

Overall, research indicates that the costs of entering the public bond market are lower if
rating agencies provide more accurate creditworthy assessments. However, a mini-bond
market with inflated ratings of low quality will presumably attract not only high-quality firms,
but also low-quality firms with restricted financing choices masquerading as high-quality
firms (i.e., Akerlof’s (1970) famous “market for lemons” problem). This is because low-quality
firms realize a favorable opportunity to gain access to public debt markets with lower
financing costs. But, ironically, this may lead to risk-shifting problems, which credit ratings
are believed to alleviate (Jensen and Meckling 1976).

Moreover, the favorable market conditions further fuel the motivation for low-quality firms to
issue mini-bonds. However, because ratings downgrades and mini-bond defaults have
increased, we expect investors to become more sensitive to evaluating true underlying credit
risk, thereby creating an incentive for high-quality firms to use underpricing as a signal of
quality. Our second testable hypothesis is thus:
Hypothesis 2: High-quality firms use mini-bond underpricing to signal their quality.

Dataset
To construct our German mini-bonds dataset, we first contacted all German stock exchanges
offering designated segments for bonds issued by the German Mittelstand (SMEs). We
obtained lists of the complete history of all issued bonds from all stock exchanges, thereby
ensuring the highest possible coverage and that all subsequent analyses would not be
affected by survivorship bias. Our information came from the following stock exchanges
(segment name in parentheses; number of bonds in brackets): Börse Stuttgart (bondm {33}),
Börse Frankfurt am Main (Entry {62}, and Prime Standard {16} for corporate bonds), Börse
Düsseldorf (der Mittelstandsmarkt {19}), Börse München (m:access bonds {3}), Börse
Hamburg/Börse Hannover (Mittelstandsbörse Deutschland {2}). Our initial sample consisted
of 135 mini-bonds issued over the 2004 through March 2015 period (see panel A of Table 1
for more details).

Table 1 Market overview

Full size table
We obtained balance sheet information for the 113 distinct companies issuing the 135 bonds
from Dafne (company information for Germany) and from Amadeus (company information for
Europe). Both are databases from Bureau van Dijk, which provides private company
information. Eighty issuers are in both databases; 18 are available only in Dafne, and 15 are
only in Amadeus. We use company information from Dafne when both or only Dafne
provided information, and we complemented that with data for the fifteen companies
available exclusively in Amadeus. The balance sheet items we use correspond to the year
prior to bond issuance.

We further checked all information available in both data bases for discrepancies. We found
28 entries that exhibited small differences of less than 0.1%, which we attribute to rounding
errors. For those cases, we used the data provided by Dafne. In unreported results, we
instead used the data from Amadeus and our results were virtually the same. However, for
two issuers, HELMA Eigenheimbau Aktiengesellschaft and HAHN-Immobilien-Beteiligungs
AG, all the balance sheet information on liabilities, such as short- and long-term liabilities as
well as assets, such as fixed assets, deviated substantially for the entire observation period.
In those cases, we used the information provided in the annual report.

To derive our final dataset, we excluded 1) two bonds that were not initially listed in the
mini-bond segment and that had subsequently requested a change of segment, 2) one bond
issued in 2004, which was 6 years before the others and which changed the segment
afterward, 3) 13 bonds with prospective issue volumes of greater than €200 million, because
they are not considered mini-bonds, and 4) one bond with no information available in Dafne,
Amadeus, Datastream, or Bloomberg. The final data set is comprised of 118 mini-bonds
(see Table 1, panel A, for a detailed overview).

However, we reduced the dataset further when calculating mini-bond underpricing, because
prices were only available in Datastream for 98 mini-bonds. Finally, we excluded any early
mini-bond defaults, which occurred up to 2 years after issuance. Consequently, the latest
possible issue date we can consider is March 31, 2013, which leaves us with 73 mini-bonds.

For the multivariate analyses in Tables 8 and 9, we use, e.g., several balance sheet-related
control variables that were not available for all mini-bonds in Dafne or Amadeus. This further
reduced the number of observations, depending on which variables were used in the
respective models (see again panel A of Table 1 for a detailed overview).

Given our maximum sample size of 118, we decided to use the highest possible number of
observations available for the respective specifications in the multivariate analyses and not
the least common factor, which would only be 42 observations.Footnote 11 Table 2 shows
the historical development of the number of mini-bond issuances and their prospective issue
volumes for the various exchanges from 2010 through May 2015. The respective industries
are in panel B of Table 1.

Table 2 Market overview

Full size table
From Table 2, we can infer that the average size of a German mini-bond is approximately
€43.47 million, indicating a rather small issue volume in these market segments. This may
also be the reason why many issuers chose face values of €1000 (although differences
among the five German stock exchanges in terms of the mini-bonds issued and their volume
are quite substantial). Thus, it is not surprising that most firms chose Stuttgart’s bondm, the
first segment to focus on mini-bonds, or Frankfurt’s Entry Standard, because Frankfurt is by
far the largest stock exchange.

We obtain bond prices by using two independent gathering approaches. First, we used the
unique identifiers (ISINs) provided by the exchanges and bond prices from Datastream’s
variable Primary Exchange. In summary, we found prices for 98 bonds in Datastream.
Second, we used bond prices from the issuing exchanges as a robustness check. We were
able to obtain prices for 116 bonds. Note that the analyses we present here are based on
the first approach because it is directly replicable. When comparing both approaches, we
find that the bond prices (when available in Datastream) are virtually the same.

Bond characteristics, such as coupon, maturity, etc., come from Datastream and are
double-checked against information given in the bond prospectuses around the issuing date.
Bond ratings are hand-collected from the respective bond prospectuses or from the related
ratings summaries from Euler Hermes, Scope, Feri, or CreditReform around the issuing
date. All ratings are short term, within a 12-month period.

Methodology
We calculate the underpricing for mini-bond offerings similarly to how IPO underpricing is
calculated (see, e.g., Cai et al. 2007). Due to the illiquidity in corporate bond markets, we
follow Cai et al. (2007) and calculate initial returns (underpricing) to investors if liquid bond
prices available within the first six calendar days after the offering are as follows:

Underpricingi=Pi,nPi,0−1
(1)
where P i , n is the closing price at the n’th trading day, which corresponds to the first
trading day after issuance with at least one trade, and P i , 0 is the bond offering price. This
procedure is commonly used (see, e.g., Cai et al. 2007; Hale and Santos 2006).Footnote 12

To estimate the following OLS regression models, we use the independent variable
Underpricing, defined as in Eq. (1). The explanatory variables are Equity Ratio, Relative
Offering Size, Implied PD z-score, ∆ Implied PD, Coupon, and Intangible Assets, and other
control variables (Time-to-Maturity, Listed, and ROA) (see Table A1 in the online appendix
for variable descriptions and calculation method).Footnote 13 The basic structure of our
regression equations is as followsFootnote 14:

Underpricing=α+β1·Equity Ratio+β2·Relative Offering Size+β3·Implied PD+β4·ΔImplied

PD+β5·Coupon+β6·Intangible Assets++∑jγj·Controlsj+εt.
(2)
We use two-way, firm and issue year, clustered standard errors, and we omit firm-level
notations for clarity.

The Implied PD in Eq. (2) is calculated using a two-step procedure. First, we calculate the
Altman z-score as follows (see Altman et al. 1977; and Altman and Saunders 1998):

z=6.56·X1+3.26·X2+6.72·X3+1.05·X4,
(3)
where X1 is the ratio of working capital to total assets, X2 is the ratio of retained earnings to
total assets, X3 is EBIT to total assets, and X4 is book value of equity to total liabilities.

Next, we transform the Altman z-score in a probability to default (Altman 2010):

Implied PD z−score=11+ez.
(4)
The major drawback of the above transformation is that the derived probabilities of default
cannot be compared directly with those from rating agencies for multiple reasons, including
mechanical enforcement, ignoring macroeconomic factors, and non-continuous probabilities
of default caused by ratings categories (see, for example, Altman and Saunders 1998;
Bandyopadhyay 1999; Goel and Thakor 2015). To counter this problem, Altman and
Saunders (1998) proposed a “mapping” to translate z-scores into probabilities of default,
which are much more comparable to those provided by Standard & Poor’s and Moody’s. We
can thus calculate bond rating equivalents using the z-score from Eq. (3) and adding a
constant term of 3.25 (see Table 4 in Altman and Saunders 1998). This approach has the
advantage that the mapping does not rely on a transformation, but on economically
meaningful criteria instead.

For our further analyses, we use the logit transformation of Altman’s z-score as our main
metric, because it appears to be the standard approach in the literature and has the
advantage of being able to produce continuous probabilities (for an incomplete list, see, for
example, Pindado et al. 2008; Wennberg et al. 2010; Tykvová and Borell 2012; Behr et al.
2013; Locorotondo et al. 2014; and Campa and Camacho-Miñano 2015). However, the
downside, of course, is the lack of a clear interpretation as well as a certain sensitivity to
returns from rating agencies in the calculation. We controlled for the latter by winsorizing at a
2.5% level on both sides. Furthermore, as a robustness check for Implied PD, we also
applied the mapping and Ohlson’s o-score implied probabilities of default (see Table A2 in
the online appendix).

To determine whether an early default occurred within the first 2 years after bond issuance,
we estimate the following logit model using the mini-bond underpricing calculated in Eq. (1)
as follows:

Early Default (0/1)=α+β1·Underpricing+β2·Equity Ratio+β3·Relative Offering

Size+β4·Implied PD+β5·ΔImplied PD+β6·Coupon+β7·Intangible Assets++∑jγj·Controlsj+εt.
(5)
Similarly to the OLS regression, we use two-way, firm and issue year, and clustered
standard errors, and we omit firm-level notations for clarity. In the robustness section, we
change the Altman z-score to Ohlson’s (1980) o-score (see Table 10 and Table A9 using
exchange data).

Results
Univariate analysis—default risk and ratings migration
In this section, we first analyze the issuer and mini-bond offering characteristics, which are
summarized in Table 3. Next, we investigate potential discrepancies in the assessment of
issuer credit risk by rating agencies. With regard to issue characteristics, we find that
Relative Offering Size is rather large and has a high standard deviation. On average,
mini-bond issuers raise more capital than their existing long-term and short-term debts taken
together would imply (see Table 3). A typical mini-bond issuance is comprised of an average
time-to-maturity of 5 years, and no longer than 7 years, which is lower than the average
duration of US corporate bonds (see, e.g., Welch 2000). The average yield to maturity is
about 7.3%, which generally increases with lower ratings categories.Footnote 15

Table 3 Summary statistics

Full size table
Moreover, we observe high average coupon rates and a rather low Equity Ratio, indicating
that highly leveraged firms are the primary users of mini-bond issues. This view is also
supported by the Implied PD z-score, suggesting a 13.5% average probability that issuers
will default on their liabilities within the next year. Remarkably, we observe that the
difference between the probability of default according to an issuer’s rating and the
probability of default implied by the z-score is on average −12.2%. This indicates that rating
agencies estimated a much lower credit risk than Altman’s z-score would have implied being
statistically significant at the 1% level.

We also find that approximately one-third of all issuers are publicly listed companies.
Because listed companies are generally covered by financial analysts and tend to be more
mature, they are typically less prone to asymmetric information. We therefore expect to find
a positive and statistically significant correlation coefficient between the variables Listed and
Equity Ratio and a negative correlation for Coupon (see Table 4).Footnote 16 In contrast,
privately held companies (when externally financed) rely almost exclusively on bank
financing and tend to be smaller than publicly listed companies. Higher default probabilities
typically coincide with low operational profitability (ROA), which is supported by the negative
correlation coefficient in Table 4.

Table 4 Correlation matrix

Full size table
The histogram in Fig. 1 shows the frequency of the implied probabilities of default for the
initial mini-bond ratings for all categories. We compare the initial mini-bond ratings with the
implied probabilities of default suggested by Altman’s z-score (panel A), z-score mapping
(panel B), and Ohlson’s (1980) o-score (see Table A2 in the online appendix). The figures
suggest that mini-bond ratings do not concur with the estimated default risk of all applied
credit risk models and actually indicate dramatically lower credit risk. The underestimation of
the 1-year default probability is about 12% (2%) considering the implied probability of default
based on Altman’s z-score (z-score mapping), which is statistically significant at the 1% (5%)
level (see Table 5 and evidence for Ohlson’s o-score in Table A2 in the online appendix).

Fig. 1
figure1
Probability of default by ratings and implied by scores. This figure compares the probability
of default within 1 year after bond listing, compared to the implied probability of default within
1 year using Altman’s z-score in Eq. (4) (a), Altman’s z-score, and Altman and Saunders’
(1998) mapping (b)

Full size image

Table 5 Differences in probability of default by ratings and implied by Altman’s z-score
Full size table
This deviation is not only statistically significant, but also economically meaningful, because
it provides a “back door” of sorts for issuing low-quality debt securities (assuming the applied
credit risk models are reliably capturing true credit risk). Interestingly, we find that, on
average, mini-bonds have a 1-year default probability of 13.5%, which corresponds to a
rating of at least B- or worse according to Standard & Poor’s (see again Table 5). In other
words, the vast majority of German mini-bonds would be classified as junk bonds, which are
clearly not appropriate investments for uninformed private investors (again assuming the
validity of the credit risk models). However, the magnitude of the difference should not be
overinterpreted because of the related drawbacks from the transformation. The difference
between the actual probability of default implied by the rating and the mapping implied
probability of default is much smaller, but it is still statistically and economically meaningful.
In summary, the results of our univariate analysis therefore provide support for our first
hypothesis of ratings inflation, meaning that initial mini-bond ratings have been too favorable.

If the ratings provided by the rating agencies are inflated, and if the credit risk models are
accurately capturing real credit risk, we would expect over time to find a more pronounced
ratings migration toward default than would otherwise be assumed by, e.g., Standard &
Poor’s historical ratings migrations.
We analyze this development in Table 6, which shows the ratings changes after 2 years and
compares them to historically observed ratings changes over that time period. Note first the
strikingly high number of defaults (see column D, panels A and B), particularly for
investment-grade rating classes. In fact, one-third of all mini-bonds issued with BBB ratings
defaulted on their debt within 2 years (see panel B of Table 6).

Table 6 Ratings migration after mini-bond issuance

Full size table
To test whether those initial ratings were inflated, panel D of Table 6 compares the ratings
migrations of mini-bonds with historical rating changes observed by Standard & Poor’s. The
two ratings categories for which we can formulate the most reliable statements are BBB and
BB, because the majority of the 89 mini-bonds fall into both categories. The results are thus
less prone to any biased results caused by outliers. A comparison of the mini-bond ratings
migration with historical ratings migrations reveals a markedly inferior development of the
mini-bonds compared to the Standard & Poor’s benchmark (highlighted in red in panel D of
Table 6). This means that BBB-rated (BB-rated) bonds have a −32.66% (−9.77%) higher
probability of migrating from the initial rating to a default (D) rating within 2 years after
issuance than the Standard & Poor’s benchmark would predict. Furthermore, mini-bonds in
those categories are less likely to increase their ratings.

The mismatch between the historical ratings changes observed by Standard & Poor’s and
the actual changes are severe among all ratings categories. This evidence seems to prove
beyond any argument that the local agencies did a horrendous job assessing the risk of
German mini-bonds. However, the question is, was that fraudulent behavior, or a crime? We
examined all cases of mini-bond defaults and found no evidence of fraudulent ratings
activities to date. The reasons provided in the filings and in the news suggest that the major
causes of failure in the German mini-bond-market are 1) a lack of financing, 2) decrease in
sales, 3) decrease in liquidity and profit, and 4) overly high levels of debt, which in nearly all
cases hindered a company’s ability to conduct its daily business (see Table A3 in the online
appendix). These common reasons for SME bankruptcies are documented in prior literature
(see, e.g., Ropega 2011). Furthermore, we observe in Table A3 that rating of the defaulted
companies decreased over time and are unsurprising (for example, consider Enron’s debt,
which was still rated as investment-grade 4 days before it declared bankruptcy (see Hill
2005). We found only two incidents (getgoods.de AG and SiC Processing) for which
investigations were begun because of the suspicion of prospectus and financial statement
fraud by top management team members. In the case of SiC Processing, the court found
that the firm did not make false or misleading statements in its bond prospectus. Therefore,
we are convinced that our sample is not subject to any biases resulting from rating agency
manipulations. The evidence thus far points to the notion that local rating agencies were
inexperienced and presumably used inadequate ratings methodologies. At the same time,
underwriters could not be held responsible, which clearly created a lack of proper
governance and an environment for investors of ambiguous information. Within this
atmosphere, black sheep were able to free ride on investors’ positive perceptions of the
well-known hidden champions from the German Mittelstand.
Mini-bond underpricing and early mini-bond default
Against the background of our findings thus far, that initial ratings are inflated and do not
measure credit risk adequately, we posit that high-quality issuers may have an incentive to
underprice their mini-bonds to send creditworthy signals. To explore this question further, we
calculate underpricing for every mini-bond issuance and find a statistically significant 0.67%
average underpricing (see Table 7). This is slightly smaller than the percent found for US
bonds (see Wasserfallen and Wydler 1988; Welch 2000; Cai et al. 2007).Footnote 17

Table 7 Initial mini-bond returns

Full size table
However, note that we have not yet tied mini-bond underpricing to issuer quality. If
high-quality firms underprice their mini-bonds to signal creditworthiness, we posit that
proxies for an issuer’s “financial strength” will be positively correlated with underpricing, after
controlling for issuer and offering characteristics. The results of our cross-sectional
regression analysis show that the coefficient for Equity Ratio is positive and highly
statistically significant at the 1% level for all specifications in Table 8. This suggests that
firms with lower leverage, i.e., less risky and financially healthier firms, are willing to leave
more money on the table when issuing mini-bonds.

Table 8 Determinants of mini-bond underpricing

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We also find that the level of underpricing decreases statistically significantly at the 1 and
5% levels with larger Relative Offering Size. Thus, firms that raise higher debt volumes by
one-time mini-bond issuance (compared to existing debt) tend to exhibit lower underpricing
(see Table 8). This finding is consistent with the notion that low-quality firms (black sheep)
are likely to take advantage of a favorable opportunity and raise comparably higher debt
volumes. Knowing or expecting their quality to be revealed in the future reduces their
chances to successfully issue follow-up mini-bonds, however. It also clearly reduces their
incentive to imitate high-quality firms (hidden champions) and benefit from lower financing
costs in the future.

Furthermore, we find support for the idea that underpricing is less pronounced for companies
with higher default risk (Implied PD z-score). This again implies that riskier and less stable
financed companies will refrain from engaging in higher underpricing. More importantly, we
find strong evidence for a positive and statistically significant relationship at the 1 and 5%
levels in all specifications between the difference in the probability of default from initial
ratings and the implied probability of default from Altman’s z-score (Δ Implied PD). Because
the default risk assigned by the initial credit ratings tends to be lower than the predicted
default probability from credit rating models (see Table 3), the difference must be negative.
Thus, the positive coefficients in specifications 2 and 6 in Table 8 suggest that underpricing
is lower for larger discrepancies between the initial default probabilities by rating agencies
and the credit risk models. We interpret these results in accordance with the Allen and
Faulhaber’s (1989) model to mean that lower Δ Implied PDs are a proxy for low-quality firms
taking advantage of a favorable of opportunity. This is because initial credit ratings appear
unable to effectively identify them.
The promised Coupon by mini-bond issuers also provides weak evidence that riskier firms
have lower underpriced mini-bonds, because coupon size is commonly perceived to
correlate positively with credit risk. However, the coefficient is statistically significant only in
specification 7 of Table 8. Finally, we find that issuers with more Intangible Assets
underprice less. This is in line with the view that firms with higher levels of intangible assets
have more trouble coming up with additional collateral during times of (extreme) financing
pressures.

In summary, we interpret the results of our multivariate regression as a strong support for our
second hypothesis that high-quality firms have an incentive to use mini-bond underpricing to
signal quality. The result also conforms with the predictions of information-based corporate
finance theory.

In our final step, we empirically test whether underpricing has any predictive power to
differentiate between low- and high-quality firms. If, as we expect, issuers with comparably
low underpricing are revealed to be lower quality firms, and all else is held equal, then those
companies will have higher credit risk, which will result in higher default rates.

To test for this relationship, we use multivariate logistic regressions, where the dependent
variable is equal to 1 if a firm defaults on its debt within the first 2 years after mini-bond
issuance and 0 otherwise. In accordance with our expectations, we find that higher
Underpricing is negatively correlated with early mini-bond defaults. This is statistically
significant at the 1 and 5% levels, thus providing support for Hypothesis 2 (see Table 9).
Furthermore, the proxy variables Relative Offering Size and Intangible Assets have
interpretations similar to those in the previous analysis. Firms taking advantage of this
favorable opportunity (high Relative Offering Size), and those with less collateral assets
(high Intangible Assets), have higher probabilities of an early default.

Table 9 Determinants of early insolvency risk

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However, the coefficients for the Implied PD z-score and ∆ Implied PD might be surprising at
first glance because they suggest that higher credit risk, and higher probability of default
implied from credit risk models than from initial ratings, are negatively correlated with early
mini-bond defaults. These results do not alter our conclusions about underpricing as a
credible signal, however. They only suggest that in our sample more mini-bonds with
comparably lower credit risk (A, BBB+, and BBB) defaulted early (see Table 3) and that
rating agencies do not systematically inflate ratings when credit risk models indicate high
credit risk.

Robustness checks
Given the rather small sample size, we performed several robustness checks to validate the
robustness of our results. First, we increased the sample size from 98 to 116 when
calculating mini-bond underpricing by using the data from the respective bond issuing
exchange.Footnote 18 As mentioned in the “Dataset” section, the prices from the bond
issuing exchange and Datastream deviate only minimally (if prices are available in
Datastream). In Tables A4 and A5 in the online appendix, we use bond prices from bond
issuing exchanges and find results that closely match those from Datastream. All conducted
analyses are highly similar in terms of magnitude and statistical significance. We are
therefore confident that our results are not subject to any bias from using Datastream data.

To estimate the probability of default, we primarily use the transformation of Altman’s

z-score, which, despite its drawbacks, remains the most widely used approach. However, to
show the robustness of our results, we also use the mapping table from z-scores and we
change Altman’s z-score to Ohlson’s o-score, as alternatives.Footnote 19 In summary, we
find that the probabilities of default using the mapping approach and Ohlson’s o-score show
a similar picture (see Fig. 1 and Table A2 in the online appendix). Furthermore, the results
from the multivariate analyses using the mapping are also highly similar (see Table 10). The
multivariate regressions using Ohlson’s o-score reveal similar results in terms of magnitude,
but the overall significance is lower. However, that lower significance is accompanied by a
smaller sample size, because the balance sheet item “net income for the year before the
most recent year to mini-bond issue” (X9) required for the o-score calculation is generally
less available in Dafne or Amadeus. In summary, the results of the multivariate analyses
using the o-score are similar to those using the mapping or z-score, especially when using
the exchange data (see Table 10 and Table A9).Footnote 20

Table 10 Determinants of mini-bond underpricing and early insolvency risk using alternative
probability of default approaches
Full size table
In the final robustness check, we explicitly control for any influence from the credit rating by
allocating a dummy variable to each ratings group and then using those in the regressions
instead of only implicitly controlling by using “∆ Implied PD.” However, this procedure is not
without problems, because, as described above, “∆ Implied PD” is expected to correlate with
credit ratings, thereby causing multicollinearity issues. Table A8 in the online appendix
shows that the inclusion of rating group dummy variables does not alter our conclusions.
But, as expected, the (max) VIF factors increase substantially, which does indicate the
presence of multicollinearity. We applied the same exercise to our multivariate analysis to
determine early issuer insolvency risk. Unfortunately, the case of multicollinearity in these
analyses is so severe that the maximum VIF factors increase to about 3.07e+15 per
specification. Therefore, even if we can estimate the regression coefficients, any conclusions
will be subject to severe multicollinearity.

Conclusion
After the recent worldwide financial crisis, it became exceedingly difficult for many German
SMEs to obtain or increase bank financing. Since 2010, some SMEs have responded by
issuing mini-bonds in specialized market segments at various German exchanges. The
majority of mini-bond issuers were initially rated at BB and BBB levels, which suggested
generally high borrower quality. This was not surprising, because these companies (the
German “Mittelstand”) are perceived as the backbone of the economy and are often referred
to as hidden champions. However, competition in the market for issuer ratings, economic
growth, investor inexperience, as well as the demand for mini-bonds, may have contributed
to ratings inflation. This resulted in a substantial underestimation of issuer default risk.
With the lack of accuracy, investors cannot rely on ratings as their primary reference point to
assess investment riskiness, which is why rating agencies ultimately fail to reduce
information asymmetries to a large extent. Low-quality firms with a distinct desire to raise
capital can take advantage of this favorable opportunity by issuing overvalued mini-bonds
during these times. According to information-based corporate finance theory, underpricing
can serve as a credible signal that allows investors to separate low-quality black sheep from
the hidden champions.

Using a unique and hand-collected sample of all available mini-bonds issued by German
SMEs between 2010 and 2015, we found that credit rating agencies understate the credit
risk inherent in mini-bond offerings and therefore tend to inflate ratings. This result is
consistent with the observation that more mini-bonds defaulted than would be expected
using historical default probabilities in the respective ratings classes. This environment,
along with high investor demand, created an opportunity for low-quality firms to obtain debt
financing using mini-bonds.

For high-quality firms competing for external debt financing, this creates an incentive to
signal their quality using mini-bond underpricing. Our data supports the view that higher
underpricing is correlated with less riskiness and higher firm quality. On a related note,
issuers with higher underpricing are less likely to default, which could reflect firm quality.
Several tests for robustness do not alter our results.

Our results should be significantly relevant to investors, mini-bond issuers, and policy
makers. For uninformed (private) investors who are otherwise unable to distinguish between
high- and low-quality issuers, it would be advisable to use mini-bond underpricing for
assessing credit risk. In contrast, SMEs that intend to issue mini-bonds should recognize
that underpricing can help reduce asymmetric information and signal their quality, which may
place them in an advantageous position for subsequent (mini-)bond offerings.

For policy makers, our findings highlight the importance of creating regulations that will foster
a more transparent information flow, such as obligations to inform issuers and investors in
order to reduce difficulties arising from asymmetric information. A lack of investor trust will
most likely affect this young and promising corporate financing alternative negatively, not
only in Germany, where segment bondm from Börse Stuttgart has already been shut down,
but in other countries such as Italy and the UK, where mini-bonds were recently introduced.
However, the industry is still in its infancy and has already demonstrated a strong potential to
at least reduce the existing funding gap for SMEs. This topic will provide fertile opportunities
for future research, particularly with the advent of more data availability.